Interest Rates: Is the inflation dragon on the ropes?

• The Reserve Bank (RBA) Board has lifted the cash rate by 25 basis points (quarter of a percent), taking the cash rate to a 9½-year high of 2.85 per cent.

The Big Picture

• The Reserve Bank Governor has indicated that the normal or neutral range for the cash rate is 2.5-3.5 per cent. The question now is where do we go from here? At some point the Reserve Bank needs to pause and assess the impact of the near decade-high cash rate on the broader economy – and inflation in particular. The aim is to push inflation back to the 2-3 per cent target band while keeping the economy ticking along and holding on to the hard-won gains of the lower unemployment rate. Over the last few days, there have been encouraging signs of a slowing of price pressures – from the monthly Melbourne Institute inflation gauge and the S&P Global manufacturing index. And the NAB’s September business survey also showed an easing in price pressures.
• The Reserve Bank has indicated a preference for ‘normal’ 25 basis point (bp) rate hikes. Not only can rates be lifted modestly, finessing the slowdown of the economy. But the announcement effect of rate hikes – or the threat of rate hikes – adds power to the rate move. Larger 50bp hikes from here are riskier – a sledge hammer rather than hammer – and likely to mean that the interest rate objective is achieved too quickly, resulting in a move to the sidelines for a number of months. As a result, the added power of announcement effects is lost.
• Also, in recent communications, RBA speakers have expressed some concerns about the deteriorating global economic outlook and reservations about the yet unknown impact of restrictive policy on consumer spending. In fact, there is typically a 3-month lag between when the official cash rate is hiked and when household mortgage repayments materially increase. The full effect of this transmission to household budgets won’t be known for a few more months. Also, the RBA meets 11 times per year, unlike other central banks, affording it more time to incrementally lift rates by smaller amounts.
• Commonwealth Bank (CBA) Group economists expect the Reserve Bank to lift the cash rate another 25 basis points at the December Board meeting to 3.10 per cent. This gives the RBA time over the Christmas/New Year period to assess the impact of Australia’s most aggressive rate hiking cycle.

• The RBA lifted the cash rate by 25 basis points (bp) or a quarter of a per cent to 2.85 per cent – a 9½-year high. This follows a 25bp increase in October, 50bp rate increases in June, July, August and September and a 25bp increase on May 3, 2022. The RBA last cut the cash rate from 0.25 per cent to 0.10 per cent on November 3, 2020. Before the Covid-19 health and economic crisis, the official cash rate was 0.75 per cent on February 5, 2020.

The Equity Lens: What does it mean for borrowers, depositors and investors?

• Consumer spending is slowing and will slow further once a key cohort of fixed rate borrowers move their loans to those with markedly higher interest rates. Investors need to reflect on sales and earnings announcements from retailers and other consumer-focussed businesses – they could prove even more illuminating than the constant stream of economic indicators.
• The Reserve Bank Governor has identified consumer spending as the indicator to be closely watched over coming months. The hard part is to gauge price and quantity components when there is discussion if consumer spending.
• The sharemarket has already priced in a slower expansion path for Australian and global economies. Once the upward path of inflation is halted, and central banks pause rate hikes, then investors will focus on the recovery path. This transition may be already underway. But there are always setback risks, so investors must be ready to pivot. Investors should expect an even greater focus on earnings and profit margins as economic activity slows.
• Returns on residential property are now easing whereas the slowdown in annual decline in returns on shares is nearing a trough. Annual returns on residential property is 1.8 per cent while the annual decline on sharemarket returns is 3.5 per cent. So investors have choices to be made.

Originally published by Craig James, Chief Economist, CommSec